‘All Change’ shouts the guard at our local Baker Street station, and passengers have to leave the warmth and familiarity of the train they have been travelling on and stand on a cold, unfriendly platform waiting for the next train, uncertain of whether they will be able to get on and will there be a seat?…. I won’t labour the analogy too long, but in my world of international business structuring, I can also shout the words ‘All Change’. Indeed, throughout the latter part of 2014, I have been explaining the dramatic changes witnessed in 2014 in conferences and webinars, and you can view the slides I have prepared for the IBSA webinar on 10 December by looking at the IBSA website at (click here).
The four dramatic changes witnessed in 2014 which will affect all international business structuring in 2015 and beyond are the OECD BEPS (Base Erosion and Profit Shifting) initiative, the State Aid attacks by the European Commission, the increasing pressure in the US against corporate inversions, and many of the developing nations attempting to widen the source principle enabling them to increase their tax revenue from non-resident investors.
In this first newsletter of 2015, I will introduce the spectre of State Aid, but also touch on the developments in the BEPS initiative, completing the newsletter with an article written by my colleague Dmitry Zapol on a topic where, as an exception, the words ‘All Change’ are thankfully not relevant. That is the resident but non-domiciled benefits of UK tax legislation which, despite what has been minor tinkering for wealthy beneficiaries of the system, has been around for decades and shows no sign of major new initiatives. Dmitry will also cover the immigration requirements which, taken together with beneficial changes in UK corporate tax law over the past decade, has resulted in the UK definitely being open to business for foreign nationals and multi-national companies.
State Aid investigations gained momentum following a leak from a whistle blower in Luxembourg that 548 tax rulings were currently being investigated by the European Commission involving Luxembourg companies created by entities in the US, Japan, China, Russia, Brazil and many other countries, particularly in the EU. On 16 January 2015, the European Commission (EC) released its report that certain favourable tax rulings that Luxembourg granted Amazon, around 2003, have been preliminarily deemed to constitute illegal State Aid under European law.
State aid is any aid granted by a Member State of the European Union which distorts or threatens to distort competition by favouring certain undertakings. Recent investigations have been made in respect of tax rulings in Gibraltar, in Ireland in respect of its alleged help to Apple, Luxembourg with its alleged help to both Fiat and Amazon, and the Netherlands with its alleged help to Starbucks. The effect of State Aid investigations will be that Member States would have to withdraw past tax concessions and potentially seek repayment of any tax privileges. Clearly, there is a risk of State Aid attack if the tax system of a particular regime is too good to be true.
Although the EC opinion is at heart a transfer pricing ruling review exercise, the underlying tax strategy motivating Amazon was the use of a hybrid entity. This, according to Action Point 2 of the OECD BEPS initiative, is unacceptable business structuring on an international level, and must be eradicated. My US colleague, Robert Kiggins, and fellow committee member of the US branch of the IBSA, explains below the hybrid aspects of the Amazon case which I thought would be interesting for our readers.
A hybrid entity may be one that is, for example, taxed as a partnership in one country and as a corporation in another. A partnership is generally tax/fiscally transparent whilst a corporation is generally tax/fiscally opaque. Each country may characterize if a given entity is tax transparent or tax opaque under its tax laws. In the US, under so-called “check the box” rules, a company, other than a US corporation or the non-US equivalent of the same, can elect to be taxed in the US as either opaque (like a corporation) or transparent (like a partnership). An entity for which a US check the box election may be made is known as an eligible entity.
Amazon adopted this hybrid strategy in Luxembourg. It set up an eligible entity (“Lux SCS”, a limited partnership) in Luxembourg which was tax transparent in Luxembourg. Thus, the Luxembourg tax consequences passed through to the US partner, Amazon US. No Luxembourg tax consequences were relevant since Lux SCS had no permanent establishment (PE) in Luxembourg; this in accordance with a tax ruling since commercial enterprises otherwise would be liable to municipal business tax and its partners possibly be deemed to have a permanent establishment in Luxembourg. According to the tax ruling, as a non-resident of Luxembourg, Amazon would be subject to Luxembourg tax only on Luxembourg source income, and in the absence of a permanent establishment, the income from Lux SCS to Amazon US would be regarded as non-Luxembourg source.
For US tax purposes, Amazon US, which owned Lux SCS, elected through the check the box arrangements to have the Lux SCS taxed in the US as a corporation. Hence, barring Controlled Foreign Corporation (CFC) problems, there would be no taxation to Amazon US until repatriation to the US of the income via actual distribution.
CFC status generally creates current taxation for passive but not active income. Although the Lux SCS was a CFC and received income in the form of intellectual property (IP) royalties (which sounds passive), there is an “active royalties” exception for CFC application under SubPart F. Lux SCS functioned as an intangibles holding company and assisted in the ongoing development of certain intangible property used in the operation of the Amazon European websites through a buy in license and cost sharing agreement with Amazon US and other affiliates of the Amazon group. This appears to be enough to meet the active royalties exception.
In essence the EC report is that the royalties paid to Lux SCS by a related Luxembourg company were excessive, i.e. not justifiable under any lawful application of arm’s length pricing principles that could be expected between unrelated parties. Needless to say, in the Amazon case, the related Luxembourg company would have been subject to very high Luxembourg taxes had it not been able to reduce its taxable income by deducting the royalty payments to Lux SCS.
While the driver for the EC report was an attack on the Amazon Luxembourg transfer pricing analysis, the motivating factor for the Amazon structure was to take advantage of the hybrid “mismatch” between the US tax rules and those of Luxembourg. Lux SCS could therefore avoid Luxembourg tax since it was a partnership without a PE in Luxembourg, but not incur US tax until repatriation of profits on the basis that, as a foreign corporation under check the box rules, only distributed profits would be subject to US tax.
The consequences of similar State Aid attacks on beneficial tax rulings provided in other jurisdictions, and indeed on other companies operating in Luxembourg, could be gargantuan. What about the Maltese exemption for royalty income from certain IP, the patent box in the UK (already agreed that this will be phased out over the next 8 years), the limited spread of income agreed for finance companies in the Netherlands, Luxembourg and elsewhere? Maybe the attack will spread to those member States offering tax concessions for research and development costs? I know I may sound like Nigel Farage on one of his rampages, but where will the long arm of the European Commission end its attack on legal and appropriate international business planning?
On the topic of BEPS, on 12 January 2015, the Centre for Tax Policy of the OECD circulated the public comments received in respect of the BEPS Action Plan 6 on treaty abuse and Action Plan 7 on preventing the artificial avoidance of permanent establishment status. I won’t describe in detail the comments raised in the 754 page release on just avoiding treaty abuse, but the gist of all of the comments is as follows. The US, when it first introduced its limitation of benefits (LOB) provision in the US/Netherlands double tax treaty in 1994 within the now famous Article 26, described how only qualified residents (basically of the US and Netherlands) would be able to benefit from the use of the Dutch/US double tax treaty. The definition of ‘qualified resident’ extended to several pages of complex legislation, but nevertheless did provide a derivative benefits clause basically allowing certain non-US and non-Dutch resident entities to benefit from the treaty. This was partly conditional that they could have otherwise benefited similarly from a double tax treaty between the US and their own country of residence. Action Plan 6 of the OECD does not appear to include this so-called ‘derivative benefits’ provision, which would impact immensely on the quite proper use of intermediary holding and finance companies, for example, within a multi-national group. Dutch holding companies of foreign subsidiaries within a UK parent group, for example, would not be able to enjoy treaty benefits without a derivative benefits provision. I am sure that the OECD will take these comments on board, but the absence of a derivative benefits provision to date rather demonstrates a blinkered approach to eradicating ‘harmful tax practices’.
The second main point raised by most of the authors submitting their contributions to the OECD in relation to Action Point 6 was in connection with Collective Investment Vehicles (CIV’s). Global growth would be massively affected if CIV’s were not allowed to structure their investments through corporate entities enjoying domestic tax privileges, if these entities could not benefit from the international network of double tax treaties because of their ownership by the CIV’s (often offshore funds which would not be able to benefit from any double tax treaty arrangements).
As someone who embraces change, I have no problem with either State Aid investigations or the OECD BEPS initiative, and have taken on board the fact that the warm, cosy train in which I have been sitting for the past 40 years has now arrived at its terminus. However, before careering off on another train in uncharted waters, I would like the driver (the OECD and European Commission) to deliver changes with which the international business community can still function and contribute to global growth.
It goes without saying that I wish all our readers a happy new year and that we all weather the storm clouds that are threatening on the horizon.
With kind regards
Roy Saunders
“Open all hours” – the UK approach
The UK encourages foreign direct investments by granting high net worth individual investors and their families the right to reside temporarily in its territory, with the associated tax benefits of the resident ‘non-dom’ regime. And after a qualifying period, whose length depends on the amount invested in the British economy, the individual and their kin can obtain indefinite leave to remain (ILR) in the UK. Later, they can even apply for British citizenship.
The Immigration Rules that regulate the process are extremely complex. The most significant amendments became effective on 6th November 2014 following an extended period of scaremongering and rumours, which mostly turned out to be true. The new rules doubled the investment threshold and only gave panicked HNW migrants 20 days to apply under the old rules or face an expensive revision of their investment plans.
The Home Office’s explanatory notes are comprehensive; however, clients rarely submit visa applications themselves. Usually they engage a triad of advisors who are experts in the fields of UK immigration law, financial and tax planning. It is not a coincidence that the tax consultants are right at the end of the list — experience has shown that despite moving to a high-tax country, seeking comprehensive tax advice often comes as an after-thought, when the investments are made and the arrival dates are set. This article highlights the primary tax planning considerations relevant to non-domiciled investors at different stages of the UK immigration process for high-value migrants.
Immigration
There are two pathways that such high-value migrants can take — Tier 1 (Investor) and Tier 1 (Entrepreneur), although this article focuses on the planning opportunities for the former. These differ in the size of the investments and the commitments on behalf of the migrant. The Home Office’s website (click here) explains the regimes in detail and contains policy guidance documents (click here) extracts from which the author used in writing this article.
The Tier 1 (Investor) category is for high-net-worth individuals who can afford to invest at least £2 million in the UK. The investor does not need a job offer in the UK nor is he required to prove a good command of the English language although the latter will be required when applications for ILR and settlement are made. Broadly, the funds must be his own savings or belong to his spouse or a partner — the Rules no longer permit borrowing the funds. According to Home Office’s statistics (click here) in 2013, the Chinese received the largest number of investor visas, followed by the Russians; the rest of the nationalities trailing behind. Anecdotal evidence suggests a significant number of the investors being wives of wealthy foreigners; the latter, together with the couple’s children being her dependants, who are free to visit the UK as they please without any commitments as to the duration of visits or making the investments.
For the sake of completeness, Tier 1 (Entrepreneur) is for non-European migrants who want to invest in the UK by setting up or taking over, and being actively involved in the running of, a UK business or businesses. Broadly, the applicant needs to invest £200,000 in a UK company and comply with a host of other requirements, including speaking English to a certain standard and having enough money to support himself in the UK. This route is attractive to younger entrepreneurs who might have sufficient savings and are prepared to actively manage the business and create jobs in the UK. In fact, certain graduate entrepreneurs are allowed to apply with only £50,000. With the recent tightening of the rules allowing foreign students to seek work in the UK after finishing their studies, the Entrepreneur visa has become especially popular with parents willing to help their children to stay in the UK.
Both routes allow the migrant to apply for the ILR after a continuous residence period in the UK of five years. This can be reduced to three years for the investor who invests £5 million or the entrepreneur who makes extraordinary progress with developing his business. A further reduction to two years is available to the investor who invests £10 million. Interestingly, the Rules only allow the main applicant to reduce the length of time before he applies for the ILR and exclude his dependants, who need to wait the whole five year period before submitting the application. There are also strict requirements regarding the number of days that the migrant can spend outside the UK in any 12-month period (click here) Failing to meet them will result in the inability to apply for the ILR and settlement.
Statutory Residence Test
Taxation in the UK primarily depends on a person’s residence status. Since April 2013, residence has been determined under the statutory residence test (SRT). The SRT is explained in brochure RDR3 (click here) which also contains useful practical examples, which are worth reviewing by anyone attempting to ascertain their residence situation. The SRT establishes residence status according to the number of days that an individual spends in the UK during the tax year that runs between 6 April and 5 April of the following calendar year. Residents generally pay tax on their worldwide income and gains, whilst non-residents are generally only taxed on income from sources in the UK. However, individuals resident but not domiciled in the UK can elect to be taxed on the remittance basis where non-UK income and gains are only liable to tax when directly or indirectly remitted (brought) into the UK.
On its own, an individual’s immigration status or current nationality has no bearing on his UK tax liability whatsoever. The investor should be treated as a regular typically non-domiciled taxpayer who requires the usual pre- and post-arrival tax planning measures. Nevertheless, tax advice should take into account two considerations that pertain to the granting of the Tier 1 (Investor) status.
Firstly, assume that the end goal of most investors and their families is to settle in the UK. To achieve this they must spend at least 185 days in every 12-month period in the UK starting from the day of arrival in the UK under the newly issued leave to enter. This immediately denies the benefit of the UK-residence planning techniques based on the extended periods of absences from the UK. As a result, most tax planning measures should be undertaken before the investor’s arrival in the UK during Stage one as explained below.
Secondly, the Rules require the investors to physically bring the investment funds into the UK. Unless these are derived from clean capital, accumulated during the period of non-UK residence, the investor will suffer the consequences of making a remittance of foreign income or gains, which will be taxed at the appropriate rates. Further remittances might occur where the investor pays for the services rendered to him in the UK, such as immigration advisors’ and solicitors’ fees. Taxation of remittances can be avoided under the business investment relief as described below; however, the expense of planning for the minimisation of the tax burden might nullify the tax benefits it aims to achieve.
The Tier 1 (Investor) process
It is possible to split the Tier 1 (Investor) immigration process in three stages. Stage one is preparatory during which the migrant collects documents and submits the visa application. As Stage two, the investor arrives in the UK after receiving leave to enter the country. Stage three involves the migrant making the investment, which will permit him to remain in the UK and to apply for the extension of his stay until he can apply for the ILR and later for citizenship. There might be a period of several months between Stages one and two during which the investor stays in his home country waiting for the outcome of the application. The migrant typically has up to three months from the day of his arrival in the UK to fulfil the requirements of Stage three. The investor should plan to remain non-UK resident at Stage one and even partly through Stage two; and during this period of non-residence he should aim to perform the larger share of his tax planning strategy.
During Stage one the applicant prepares and submits documentary evidence of his ability to invest at least £2 million in the British economy. This amount must be in cash and kept in a regulated financial institution (typically a bank) in the UK or overseas. Sometimes instead of clear funds the future migrant has an asset portfolio that includes capital assets and undistributed income, but the Home Office will not take these into consideration. Funds held by companies or trusts are equally excluded. The investor should convert these assets into cash: any gains accumulated in securities and properties should be crystallised by selling them; where there is a right to receive income — dividends, interest, salary, royalties, business profits — this right should be exercised and the proceeds received into a bank account.
It might seem reasonable only to create sufficient cash to fund the £2 million investment. In fact, when converting assets into cash or receiving income, the investor might be subject to a double tax liability, determined by his current tax residence and the source of funds, although this might be reduced under double tax agreements or domestic tax exemptions. However, any non-UK gain that is crystallised and non-UK income that the investor receives after he becomes UK resident will be liable to UK’s fairly high taxes unless the taxpayer claims the remittance basis of taxation and does not bring the funds to the UK. As a result, the migrant might face the situation where he cannot pay for his life in the UK without incurring a significant tax cost.
‘Clean capital’
Conversely, income and gains received before becoming resident form so-called “clean capital”. If the investor loans clean capital to someone, the loan principal will always remain clean capital when repaid to the investor (but note the position with regard to loan interest below). Gifts received from related and third parties are also clean capital provided they are not considered to be a form of hidden income or gains distribution. In practice, some UK-resident investors live off the gifts made to them from their non-UK resident spouses, who earn income and gains not liable to UK tax. Clean capital will not be taxed in the UK, whether brought in its territory or not. However, in the case of an investor’s death, clean capital kept in a UK bank account will form his UK-situs asset liable to 40% inheritance tax. Therefore, it might be prudent to bring to the UK only the amounts necessary to fund current expenses.
Clean capital should be credited to a separate bank account and never mixed with non-UK income and gains that might be derived after assuming UK residence. In fact, considering that income and gains are taxed differently in the UK, they should also be kept in separate bank accounts. Moreover, if clean capital generates income — say it has been loaned and the investor receives interest — this should be paid to the income bank account and not into the clean capital account to avoid tainting it. Counterintuitively, the same cannot be done with gains generated with the use of clean capital. For example, if clean capital is used to buy shares, any gain realised on their future disposal will always form part of the proceeds and it cannot be segregated from clean capital by being paid to a separate bank account. There are methods that allow for such separation of gains involving the use of several connected trading entities or loaning clean capital to a bank to secure a bank loan, which will later be used to acquire capital assets.
If the investor runs out of clean capital he might have no choice but to bring foreign income and gains to the UK and face the prospect of the maximum 45% taxation. He can borrow from an overseas lender provided that the loan is made on commercial terms and the interest is serviced from UK-source income or gains. It had been possible to borrow under security of non-UK income and gains; however, in August 2014 this possibility was revoked.
There is no requirement or in fact possibility to declare clean capital to the UK tax authorities (HMRC) upon becoming UK resident. Equally, there is no requirement to report the use of clean capital on UK’s tax returns. However, the taxpayer should keep documents that reflect dates and methods of creation of non-UK income and gains to prove that they were received while he was non-UK resident and thus form his clean capital. Such documents include bank statements, sale and purchase agreements, loan agreements. They might be necessary in case of a future dispute with HMRC.
The Rules also allow the investor to rely on money that is owned either jointly with or solely by his close relative (spouse or partner). If the close relative is a lower rate taxpayer then, subject to the rules of their residence jurisdiction, the investor can gift the assets to the relative, which she can dispose of subject to the payment of a smaller amount of tax.
Provided the requirements of stage one are satisfied, the investor will receive the leave to enter the UK as a Tier 1 (Investor). The arrival to the UK should be timed with regards to the residence planning considerations as discussed next. At the same time the investor should not delay his arrival in order to satisfy the continuous residence requirement required to apply for the ILR at the end of his stay.
‘Connecting factors’ of tax residence
Under the SRT UK residence may be acquired automatically if the individual spends over 182 days in the UK, has a home in the UK or works in the UK on a full-time basis. If the investor is not UK-resident automatically, he might be resident under the sufficient ties test, which looks at the connection ties that the individual has with the UK. The relevant factors include having a family resident in the UK, presence of UK accommodation, working in the UK and length of visits to the UK in the preceding tax years. The more UK ties the investor has — the less number of days he can spend in the UK during the tax year without becoming a UK tax resident. It is also possible to be automatically non-UK resident under a separate set of circumstances. Residence is determined for the entire tax year starting from 6th April regardless of the taxpayer’s relocation date. However, there is a possibility to split the tax year and only begin UK tax residence from the day of arrival in the UK.
Experience shows that in the tax year of arrival in the UK, most investors have two connection ties: they acquire a home in the UK and their families become UK resident. The SRT allows them to stay in the UK for up to 120 days without becoming resident here provided they are not UK resident automatically. However, there are plenty of pitfalls and before determining his residence situation, the investor should avoid buying accommodation in the UK or entering into long-term leases, moving family and sending children to school and spending over 90 days in the UK in any tax period. Additional planning opportunities might be offered by the tie-breaker clause in the residence article of the double taxation treaty that the UK might have with investor’s residence State, although complications might arise stemming from the mismatch between the tax years’ periods. HMRC provides an interesting explanation of this rule in part INTM154040 of its International Manual (click here) .
Under Stage three the investor must invest £2 million by way of UK Government gilt-edged securities, share capital or loan capital in active and trading companies that are registered in the UK. The minimum investment threshold must be met only when the investments are made and there is no need for a top-up if their value falls during the continuous ownership period. It is also possible to rely on the existing investments, however, the Home Office will only count those that have been made in the UK in the 12 months immediately before the date of the application. Otherwise, the investor will have to make “fresh” investments, which might trigger tax consequences in the UK or in his residence State if to do so he would have to realise assets pregnant with gains.
Remittance rules and Business Investment relief
Provided that the investment comprises clean capital accumulated during Stage one, there will be no UK tax consequences on bringing the funds in the UK. In the opposite scenario, where the investments consist of foreign untaxed income and gains made after the date of first becoming UK tax resident, these will constitute remittances, on which the investor will be taxed at his applicable income tax rate. HMRC explain the meaning of remittance in part RDRM33140 of its Residence, Domicile and Remittance Basis Manual (click here)
Individuals who choose security over higher returns might prefer UK Government gilts, which can also be tax advantageous — there is no UK capital gains tax on their disposal and the coupon can be structured in a way that does not attract interest taxation when paid to non-UK tax residents. Also some gilts are exempt assets for UK inheritance tax purposes. Others invest through international banks that form a balanced portfolio of low risk quoted securities. UK-resident taxpayers are taxed on dividends they receive and gains derived from disposals. These methods are preferable for individuals with large amounts of clean capital that they can bring and invest in the UK without any tax consequences.
Investors with non-UK income and gains that will be taxed on remittance to the UK and who are not averse to risk might instead buy shares of UK trading unquoted companies or provide the funds to such companies as loans. The only limitation is that the companies cannot be mainly engaged in property investment, property management or property development, although it does not prevent investment in, for example, construction firms, manufacturers or retailers who own their own premises.
If they satisfy terms of the business investment relief (click here) the invested amounts shall not be treated as remittances and shall not be liable to UK tax. There are additional income tax and capital gains tax reliefs such as EIS, SEIS and VCT intended to encourage investment in the shares of unquoted trading companies. Finally, if the investor is appointed director or taken on as an employee of the company in which he has invested, he might be able to receive a substantial reduction on future disposal of its shares under the terms of the ‘Entrepreneurs’ Relief’ where the personal tax rate may be 10% on gains made.
Thus pre-arrival tax planning for a Tier 1 investor is a complex matter that should be done prior to finalising immigration plans. Future migrants should consider their medium to long-term planning strategy, which includes residence planning, creation of clean capital and acquisition of assets in the UK.
Dmitry Zapol